Franking credits, also known as imputation credits, are a unique feature of the Australian tax system designed to prevent double taxation of company profits when distributed as dividends to shareholders.
Key Takeaways
- The tax benefits of franking credits make them particularly attractive to shareholders, especially those in lower tax brackets or retirees.
- Franking credits align dividend income with an individual’s personal tax rate, preventing double taxation.
- Fully franked dividends provide the maximum tax benefit, but partially franked dividends can still be advantageous.
- The refundable nature of franking credits makes them valuable to individuals with lower overall incomes, including self-funded retirees.
How Franking Credits Work:
- Corporate Taxation: When an Australian company generates profits, it is required to pay corporate income tax on those earnings at the prevailing corporate tax rate. As of my last knowledge update in September 2021, this rate was 30%.
- Dividend Distribution: After paying corporate taxes, the remaining profits can be distributed to shareholders as dividends. These dividends may come with an attached “franking credit,” which represents the amount of tax the company has already paid on those profits.
- Tax Offset: Shareholders who receive dividends with franking credits can use these credits as a tax offset when they report their income on their individual tax returns. The franking credits effectively reduce the tax liability on the dividend income.
Example of Franking Credits:
Let’s illustrate this with a simplified example:
Suppose you are an Australian shareholder who owns shares in Company X. Company X generates a profit of $1 per share before taxes. The corporate tax rate is 30 cents on every dollar of profit, so the company pays 30 cents in tax on each dollar earned. After-tax, the company has 70 cents left.
Company X decides to distribute these profits as dividends to its shareholders. When you receive a dividend of 70 cents per share, it comes with a franking credit of 30 cents because the company has already paid 30 cents in tax.
Tax Impact:
Now, when you file your individual tax return, you will declare the entire $1 (70 cents dividend plus 30 cents franking credit) as part of your income. If your personal marginal tax rate is lower than the corporate tax rate (30%), you will be entitled to a refund for the excess franking credits. In this scenario, franking credits effectively reduce your tax liability or provide you with a cash refund.
Conversely, if your marginal tax rate is higher than the corporate tax rate, you will need to pay additional tax on top of the franking credits.
Suggested Read: How to Lodge Tax Return in Australia?
Why Franking Credits Matter:
- Tax Fairness: Franking credits help ensure that shareholders are not taxed twice on the same company profits, which would be unfair and discourage investment.
- Appeal to Retirees: Franking credits are particularly popular among retirees because they can provide valuable tax refunds, especially for those with lower overall income.
- Impact on Government Revenue: Critics argue that franking credits reduce the amount of tax revenue collected by the government, potentially affecting public services. However, supporters believe they are essential for supporting retirees.
Types of Franking Credits in Australia
In the context of Australian franking credits, there are primarily two types: fully franked dividends and partially franked dividends. Let’s explore these types with clear explanations and examples:
1. Fully Franked Dividends:
Fully franked dividends are dividends that come with franking credits representing the entire amount of tax that the company has already paid on its profits. These are the most tax-efficient dividends for shareholders.
Example: Suppose Company A generates a profit of $1 per share before taxes. The company pays 30 cents in corporate tax on each dollar of profit, leaving 70 cents after taxes. When it distributes dividends to its shareholders, it attaches 30 cents in franking credits to each dollar of dividends. This means that the entire tax amount has already been paid by the company, and shareholders can usually claim the entire franking credit to offset their own tax liability. [Source]
2. Partially Franked Dividends:
Partially franked dividends, on the other hand, are dividends where the company attaches franking credits representing only a portion of the tax paid on its profits. These dividends indicate whether the company paid taxes on the entire amount of profits distributed as dividends.
Example: Imagine Company B generates a profit of $1 per share before taxes. However, it only attaches 20 cents in franking credits to each dollar of dividends it distributes. This means the company has paid taxes on only 20 cents of the profit per share. Shareholders receiving partially franked dividends can still use the attached franking credits, but they may not cover the full amount of tax owed on the dividends [Source].
Facts to Consider:
- Fully franked dividends are generally more attractive to investors because they provide the maximum tax benefit.
- Partially franked dividends are a common scenario when a company hasn’t paid taxes on the entire amount being distributed to shareholders.
- The choice between fully franked and partially franked dividends depends on the company’s tax situation and its available franking credits.
- Investors should pay attention to the franking credit percentage when assessing the tax benefits of dividends.
- It’s essential to consider your individual tax circumstances and marginal tax rate when evaluating the impact of franking credits on your overall tax liability.
Tax Benefits of Franking Credits:
Franking credits offer several key tax benefits to shareholders, which contribute to making Australian dividend investments attractive:
1. Cash Refunds:
- If the franking credits on your dividends exceed your tax liability, you may be eligible for a cash refund from the government. This means you receive money back, providing additional income.
Example: Let’s say you receive a fully franked dividend of $1 per share, which includes 30 cents in franking credits. If your personal tax rate is 20%, you owe 20 cents in taxes on this income. However, since the franking credits are 30 cents, you are eligible for a 10-cent cash refund.
2. Lower Taxes:
- Franking credits act as a tax offset, reducing the amount of income tax payable. They are used to offset your individual tax liability, resulting in a lower overall tax bill or an increased refund.
Example: Suppose you receive a partially franked dividend of $1 per share, with 20 cents in franking credits. Your tax liability at a 20% personal tax rate is 20 cents. However, the 20 cents in franking credits offset this liability entirely, leaving you with no additional tax to pay.
3. Increased Returns on Investments:
- Shares in Australian companies that pay dividends with franking credits boost your investment returns. The franking credits represent tax already paid by the company, so you effectively receive a higher after-tax dividend.
Example: Consider a dividend of $1 per share from a fully franked source, as mentioned earlier. Without franking credits, you’d receive only 70 cents after-tax. However, with the 30 cents in franking credits, your after-tax income remains at $1 per share.
Franking Credits are Controversial in Australia for Several Reasons.
While they have their proponents, there are significant debates surrounding their impact on the country’s tax system and government revenue. Here’s a clear and easy-to-understand explanation of why franking credits are a contentious issue:
1. Perceived Benefit to the Wealthy:
Critics argue that franking credits disproportionately benefit higher-income individuals and self-managed superannuation funds (SMSFs), which are essentially retirement savings accounts managed by individuals. This is because these individuals have larger investments in shares and, as a result, receive more substantial franking credit refunds [source].
Example: Consider a high-net-worth individual with a substantial share portfolio. If their franking credits exceed their tax liability, they can receive substantial cash refunds, effectively reducing their tax burden and increasing their income.
2. Impact on Government Revenue:
Franking credits reduce the amount of tax revenue that the government collects. When individuals receive cash refunds for excess franking credits, it means the government is returning tax money to taxpayers, which could otherwise be used for public services like healthcare, education, and infrastructure.
3. Political Controversy:
Franking credits became a major point of contention in Australian politics. The Australian Labor Party’s proposal to change the treatment of franking credits during the 2018 federal election campaign generated significant controversy. Labor’s plan, which would have limited cash refunds for excess franking credits, was met with strong opposition from retirees and investors.
Example: The 2018 federal election was seen by many as a referendum on Labor’s franking credits policy. Labor’s electoral defeat was attributed in part to this proposal, and the party subsequently abandoned it in the next election.
4. Debate Over Fairness:
The debate around franking credits centers on whether they make the tax system less fair. Critics argue that providing cash refunds for franking credits benefits a select group of investors, while supporters contend that it supports retirees who rely on dividend income.
Proponents’ Perspective: Supporters of franking credits argue that they are an important part of the tax system to support retirees, especially those with low incomes. For self-funded retirees with limited income, cash refunds from franking credits can make a significant difference in their financial well-being.
Who Benefits from Franking Credits in Australia?
1. Self-Funded Retirees:
Self-funded retirees with low taxable incomes can benefit significantly from franking credits, as they may receive cash refunds for excess credits.
As of 2020, it was estimated that self-funded retirees received over $5 billion in franking credit refunds annually.
Suggested Read: 10 Self-Employment Tax Deductions and Benefits for Australians
2. Low-Income Investors:
Investors in lower tax brackets benefit from franking credits because the credits can reduce their tax liability or result in refunds.
In 2020, over 2 million individuals in the lowest tax bracket received franking credit refunds.
3. SMSFs (Self-Managed Superannuation Funds):
SMSFs, especially those with diverse share portfolios, can benefit from franking credits, which contribute to higher returns.
SMSFs held approximately 30% of the total value of Australian shares as of 2021.
Investors who hold shares for the long term can accumulate franking credits over time, enhancing their overall returns.
Long-term investors make up a significant portion of the Australian share market, with many benefiting from franking credits.
5. High-Income Earners:
While high-income earners may not receive cash refunds, they can still benefit from lower taxes on their dividend income due to franking credits.
High-income individuals often have substantial investments in Australian shares, contributing to their overall wealth.
6. Australian Companies and Dividend Payers:
Australian companies benefit from franking credits as they can attract investors with the promise of tax-efficient dividend income.
Many Australian companies have a long history of paying fully franked dividends to shareholders.
Shareholders in companies that pay fully franked dividends benefit the most, as they can claim the maximum available franking credits.
Fully franked dividends make up a significant portion of total dividend payments in Australia.
8. Investors in Tax-Advantaged Accounts:
Investors who hold shares in tax-advantaged accounts, such as superannuation funds, can benefit from franking credits with reduced tax rates.
Superannuation funds collectively held over $2.9 trillion in assets as of 2020, a substantial portion of which is invested in Australian shares.
9. Small Business Owners:
Small business owners who invest in shares can benefit from franking credits, potentially reducing their overall tax liability.
Small businesses represent a significant portion of the Australian economy, and many owners are also investors.
Franking Credits FAQs
When can you claim franking credits?
You can claim franking credits when you file your individual tax return. They are used to offset your tax liability or, in some cases, result in a cash refund if the credits exceed your tax liability.
Who is eligible for franking credits?
Shareholders who hold shares in Australian companies that pay fully or partially franked dividends are eligible for franking credits. The eligibility depends on the type of dividend and the individual’s tax situation.
Can franking credits be transferred?
Franking credits are generally not transferable between individuals or entities. They are attached to the dividends received by individual shareholders and can only be used to offset the tax liabilities of those shareholders. Franking credits cannot be transferred or sold to others.
What’s the difference between fully franked and partially franked dividends?
Fully franked dividends come with franking credits representing the entire amount of tax the company has already paid on its profits. Partially franked dividends have franking credits that represent only a portion of the tax paid on the profits.
Are franking credits taxable income?
Franking credits themselves are not considered taxable income. However, they are used to offset the tax liability on your dividend income when you file your tax return.
How do franking credits affect my tax return?
Franking credits reduce the amount of tax you owe on your dividend income. If your tax liability is lower than the franking credits attached to your dividends, you may receive a cash refund for the excess credits.
Do franking credits apply to all dividends?
Franking credits apply to dividends from Australian companies that have paid corporate income tax. They may not apply to dividends from foreign companies or entities that are exempt from corporate tax.
How can I maximize the benefits of franking credits?
Hold shares in companies that pay fully franked dividends, especially if your personal tax rate is lower than the corporate tax rate. Consult with a tax professional to optimize your tax strategy.
What documents do I need to claim franking credits on my tax return?
You need your dividend statements from the companies in which you hold shares to claim franking credits on your tax return. These statements will show the amount of franking credits attached to your dividends.
The Bottomline
The franking credits in Australia offer significant tax benefits which can have a positive impact on the tax liability and investment returns of shareholders. The distribution of these benefits reflects the diverse nature of the Australian share market and the importance of franking credits in optimizing investment returns and supporting retirees.
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